10-Q 1 fhg01q3b.txt QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001 FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 {X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR { } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition period from ________ to ________ Commission file number 0-15846 First Health Group Corp. (formerly HealthCare COMPARE Corp.) (Exact name of registrant as specified in its charter) Delaware 36-3307583 ------------------------------- ------------------------------------ (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) 3200 Highland Avenue, Downers Grove, Illinois 60515 --------------------------------------------------- (Address of principal executive offices, Zip Code) (630) 737-7900 ------------------------------------------------ (Registrant's phone number, including area code) __________________________ (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ________ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. The number of shares of Common Stock, par value $.01 per share, outstanding on November 7, 2001, was 99,610,266. First Health Group Corp. and Subsidiaries INDEX Part I. Financial Information Page Number ----------- Item 1. Financial Statements Consolidated Balance Sheets - Assets at September 30, 2001 and December 31, 2000 ................................... 3 Consolidated Balance Sheets - Liabilities and Stockholders' Equity at September 30, 2001 and December 31, 2000....... 4 Consolidated Statements of Operations for the three months ended September 30, 2001 and 2000 ....................... 5 Consolidated Statements of Operations for the nine months ended September 30, 2001 and 2000 ....................... 6 Consolidated Statements of Comprehensive Income for the three months ended September 30, 2001 and 2000 .......... 7 Consolidated Statements of Comprehensive Income for the nine months ended September 30, 2001 and 2000 ........... 7 Consolidated Statements of Cash Flows for the nine months ended September 30, 2001 and 2000 ....................... 8-9 Notes to Consolidated Financial Statements ................ 10-14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................. 15-20 Item 3. Quantitative and Qualitative Disclosures About Market Risk .......................................... 22 Part II. Other Information Item 6. Exhibits and Reports on Form 8-K ................. 23 Signatures....................................................... 28 PART I. Financial Information First Health Group Corp. and Subsidiaries CONSOLIDATED BALANCE SHEETS (Dollars in 000's) (Unaudited) ---------------------------------------------------------------------------- ASSETS September 30, December 31, 2001 2000 ---------- ---------- Current Assets: Cash and cash equivalents ............... $ 17,438 $ 23,538 Short-term investments .................. 1,923 2,015 Accounts receivable, less allowances for doubtful accounts of $13,067 and $10,811 respectively.................. 85,034 57,137 Deferred taxes .......................... 33,832 16,480 Assets held for sale .................... 15,520 -- Other current assets .................... 12,108 14,443 ---------- ---------- Total current assets .................... 165,855 113,613 Long-Term Investments: Marketable securities ................... 65,666 58,242 Other ................................... 51,792 43,787 ---------- ---------- 117,458 102,029 ---------- ---------- Property and Equipment: Land, buildings and improvements......... 85,394 71,135 Computer equipment and software.......... 184,689 148,846 Office furniture and equipment........... 21,906 16,597 ---------- ---------- 291,989 236,578 Less accumulated depreciation and amortization.......................... (111,443) (80,861) ---------- ---------- Net property and equipment .............. 180,546 155,717 ---------- ---------- Goodwill, less accumulated amortization of $14,953 and $12,355, respectively........ 259,049 89,975 Intangible assets, less accumulated amortization of $239 and $0, respectively 43,575 -- Reinsurance recoverable.................... 27,320 28,215 Other Assets............................... 2,169 2,047 ---------- ---------- $ 795,972 $ 491,596 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries CONSOLIDATED BALANCE SHEETS (Dollars in 000's) (Unaudited) ---------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY September 30, December 31, 2001 2000 ---------- ---------- Current Liabilities: Accounts payable ........................ $ 35,344 $ 31,727 Accrued expenses ........................ 68,101 28,603 Current maturities of long-term debt..... 240,000 -- Claims reserves ......................... 13,514 13,013 Income taxes payable .................... 10,477 -- ---------- ---------- Total current liabilities ............... 367,436 73,343 Long-Term Debt............................. -- 127,500 Claims Reserves - Non-Current.............. 27,320 28,215 Deferred Taxes............................. 73,095 58,621 Other Non-Current Liabilities.............. 23,438 22,504 ---------- ---------- Total liabilities ....................... 491,289 310,183 ---------- ---------- Commitments and Contingencies.............. -- -- Stockholders' Equity: Common stock ............................ 1,308 795 Additional paid-in capital .............. 297,530 252,092 Retained earnings ....................... 609,859 534,428 Accumulated comprehensive gain(loss)..... 379 (1,509) Treasury stock, at cost ................. (604,393) (604,393) ---------- ---------- Total stockholders' equity .............. 304,683 181,413 ---------- ---------- $ 795,972 $ 491,596 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in 000's except per share amounts) (Unaudited) ---------------------------------------------------------------------------- Three Months Ended September 30, -------------------------- 2001 2000 ---------- ---------- Revenues............................. $ 152,207 $ 128,065 ---------- ---------- Operating expenses: Cost of services .................. 66,818 56,846 Selling and marketing ............. 15,150 12,359 General and administrative ........ 10,764 8,530 Healthcare benefits ............... 3,121 3,412 Depreciation and amortization ..... 12,076 9,878 ---------- ---------- 107,929 91,025 ---------- ---------- Income from operations............... 44,278 37,040 Other (income) expense: Interest expense .................. 1,694 3,627 Interest income ................... (1,727) (1,466) ---------- ---------- Income before income taxes........... 44,311 34,879 Income taxes......................... (17,947) (14,126) ---------- ---------- Net income $ 26,364 $ 20,753 ========== ========== Weighted average shares outstanding - basic................ 99,280 95,788 ========== ========== Net income per common share - basic.. $ .27 $ .22 ========== ========== Weighted average shares outstanding - diluted.............. 103,946 99,750 ========== ========== Net income per common share - diluted $ .25 $ .21 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in 000's except per share amounts) (Unaudited) ---------------------------------------------------------------------------- Nine Months Ended September 30, -------------------------- 2001 2001 ---------- ---------- Revenues............................. $ 428,140 $ 376,424 ---------- ---------- Operating expenses: Cost of services .................. 186,993 168,245 Selling and marketing ............. 41,327 35,746 General and administrative ........ 27,756 25,765 Healthcare benefits ............... 10,220 9,145 Depreciation and amortization ..... 33,963 28,365 ---------- ---------- 300,259 267,266 ---------- ---------- Income from operations............... 127,881 109,158 Other (income) expense: Interest expense .................. 5,284 11,672 Interest income ................... (5,292) (4,864) ---------- ---------- Income before income taxes........... 127,889 102,350 Income taxes......................... (51,796) (41,452) ---------- ---------- Net income........................... $ 76,093 $ 60,898 ========== ========== Weighted average shares outstanding - basic................ 97,908 95,656 ========== ========== Net income per common share - basic.. $ .78 $ .64 ========== ========== Weighted average shares outstanding - diluted.............. 102,660 99,510 ========== ========== Net income per common share - diluted $ .74 $ .61 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in 000's) (Unaudited) ---------------------------------------------------------------------------- Three Months Ended September 30, -------------------------- 2001 2000 ---------- ---------- Net income.................................. $ 26,364 $ 20,753 ---------- ---------- Unrealized gains on securities, before tax.. 1,309 1,810 Income tax expense related to items of other comprehensive income...................... (464) (750) ---------- ---------- Other comprehensive income.................. 845 1,060 ---------- ---------- Comprehensive income........................ $ 27,209 $ 21,813 ========== ========== Nine Months Ended September 30, -------------------------- 2001 2000 ---------- ---------- Net income.................................. $ 76,093 $ 60,898 ---------- ---------- Unrealized gains on securities, before tax.. 2,982 4,454 Income tax expense related to items of other comprehensive income...................... (1,094) (1,801) ---------- ---------- Other comprehensive income.................. 1,888 2,653 ---------- ---------- Comprehensive income........................ $ 77,981 $ 63,551 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in 000's) (Unaudited) ---------------------------------------------------------------------------- Nine Months Ended September 30, -------------------------- 2001 2000 ---------- ---------- Cash flows from operating activities: Cash received from customers ............ $ 412,557 $ 374,425 Cash paid to suppliers and employees .... (267,576) (234,577) Healthcare benefits paid ................ (10,952) (4,363) Interest income received ................ 5,494 3,872 Interest expense paid ................... (5,448) (11,339) Income taxes paid, net .................. (22,583) (10,529) ---------- ---------- Net cash provided by operating activities 111,492 117,489 ---------- ---------- Cash flows from investing activities: Acquisition of businesses, net of cash acquired ......................... (198,645) -- Purchases of investments ................ (35,959) (19,629) Sales of investments .................... 25,368 14,605 Purchase of property and equipment ...... (52,225) (38,952) ---------- ---------- Net cash used in investing activities ... (261,461) (43,976) ---------- ---------- Cash flows from financing activities: Proceeds from issuance of long-term debt. 215,000 25,000 Purchase of treasury stock .............. -- (46,059) Repayment of long-term debt ............. (102,500) (87,500) Stock option loans to employees ......... (1,500) (3,637) Stock option loan repayments ............ 838 3,671 Proceeds from issuance of common stock... 32,031 23,818 Proceeds from sale of put options on common stock........................ -- 380 ---------- ---------- Net cash provided by (used in) financing activities................... 143,869 (84,327) ---------- ---------- Net decrease in cash and cash equivalents.. (6,100) (10,814) Cash and cash equivalents, beginning of period...................... 23,538 35,639 ---------- ---------- Cash and cash equivalents, end of period... $ 17,438 $ 24,825 ========== ========== Supplemental cash flow data: Acquisition of businesses: Fair value of assets acquired, net of cash acquired ......................... 47,803 -- Goodwill ................................ 172,122 -- Intangible assets ....................... 43,814 -- Fair value of liabilities assumed ....... (65,094) -- ---------- ---------- Net cash paid ........................... $ 198,645 $ -- ========== ========== Non-cash financing activity: Stock options exercised in exchange for common stock..................... $ -- $ 8,733 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in 000's) (Unaudited) ---------------------------------------------------------------------------- Nine Months Ended September 30, -------------------------- 2001 2000 ---------- ---------- Reconciliation of Net Income to Net Cash Provided by Operating Activities: Net Income.................................. $ 76,093 $ 60,898 ---------- ---------- Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation and amortization .......... 33,963 28,365 Change in provision for uncollectible receivables........................... (497) (85) Tax benefit from stock options exercised 13,921 8,395 Deferred income taxes .................. 2,726 18,863 Other, net ............................. (3,483) (733) Changes in Assets and Liabilities: (Net of Effects of Acquired Businesses) Accounts receivable .................... (16,995) (3,240) Other current assets ................... 3,383 (4,655) Reinsurance recoverable ................ 895 18,173 Accounts payable and accrued expenses... (9,620) 1,309 Claims reserves ........................ (394) (13,736) Income taxes payable ................... 10,477 4,124 Non-current assets and liabilities ..... 1,023 (189) ---------- ---------- Total adjustments ........................ 35,399 56,591 ---------- ---------- Net cash provided by operating activities. $ 111,492 $ 117,489 ========== ========== See Notes to Consolidated Financial Statements
First Health Group Corp. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. The unaudited financial statements herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. The accompanying interim financial statements have been prepared under the presumption that users of the interim financial information have either read or have access to the audited financial statements for the latest fiscal year ended December 31, 2000. Accordingly, footnote disclosures which would substantially duplicate the disclosures contained in the December 31, 2000 audited financial statements have been omitted from these interim financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. Although the Company believes that the disclosures are adequate to make the information presented not misleading, it is suggested that these interim financial statements be read in conjunction with the financial statements and the notes thereto included in the Company's latest Annual Report on Form 10-K. 2. On August 16, 2001, the Company completed the acquisition of all of the outstanding shares of capital stock of CCN Managed Care, Inc. ("CCN") and Preferred Works, Inc. ("PW" and together with CCN, the "CCN Companies") from HCA-The Healthcare Company and VH Holdings, Inc. (collectively, the "Sellers") for a purchase price of $195 million in cash, plus a working capital adjustment which increased the purchase price to $198 million. The acquisition was effected pursuant to the terms of a Stock Purchase Agreement, dated as of May 18, 2001 (as amended as of August 16, 2001), among the Company and the Sellers. The acquisition was financed from borrowings under the Company's existing line of credit. The transaction was accounted for as a purchase of the CCN Companies by the Company for financial reporting and accounting purposes. Accordingly, the Company revalued the basis of acquired assets and assumed liabilities to fair value. The purchase price of the CCN Companies was calculated as cash paid, including the working capital adjustment, plus the Company's transaction costs. The difference between the purchase price and the fair value of the identifiable tangible and intangible assets acquired and liabilities assumed is recorded as goodwill, which will not be amortized (See Note 7). The preliminary allocation of the purchase price is subject to completion of the Company's integration and merger plan, sale of the acquired businesses that are held for sale and completion of the valuations for certain intangible assets and fixed assets. Changes to the preliminary purchase price allocation resulting from the finalization of these items may be material. The allocation of the purchase price to the fair value of assets acquired and liabilities assumed is as follows: (Dollars in 000's) ------------------ Purchase price $195,000 Working capital adjustment 3,514 Transaction costs 2,000 ------- Total estimated purchase price $200,514 ------- Purchase price has been allocated as follows: Fair value of assets acquired $ 49,672 Goodwill 172,122 Intangible assets acquired 43,814 Liabilities assumed (23,981) Liability for restructuring and integration costs (41,113) ------- $200,514 ------- In conjunction with the acquisition, the Company recorded as part of the purchase price a $41.1 million reserve for restructuring and integration costs as part of an overall plan to reduce operating expenses of the acquired companies. The specific actions included in the restructuring plan are expected to be substantially complete by December 31, 2002. Components of the purchase reserve are as follows: Total Amount Balance (Dollars in 000's) Charges Incurred 9/30/01 ------------------ ------ ------- ------- Severance and related benefits $13,712 $ (6,764) $ 6,948 Systems and facilities integration 10,370 (4) 10,366 Contract losses 10,000 -- 10,000 Other reserves 7,031 -- 7,031 ------ ------- ------- Total $41,113 $ (6,768) $ 34,345 ====== ======= ======= The restructuring plan includes the reduction of employees from various offices within the United States. The Company is in the process of finalizing its plan, but expects to reduce the number of employees from approximately 1,300 at the time of the acquisition of CCN to approximately 650 at December 31, 2002. During the third quarter, approximately $6.8 million was paid for severance and related employee benefits. Severance and related benefits represent costs for payments over the next twelve months for headcount reductions already incurred and for future reductions of employees. Systems and facilities integration costs represent the costs the Company expects to incur to convert and integrate CCN's systems and facilities into the Company's existing operations. The majority of the facilities integration costs will be incurred to consolidate CCN's former corporate headquarters and various sales offices throughout the United States. The systems integration costs will be incurred to integrate CCN's medical provider, claims repricing and bill review systems into the Company's existing operations. Approximately $4,000 of costs for systems and facilities integration has been charged to the purchase reserve as of September 30, 2001. Contract losses relate to the anticipated net loss to be incurred on a contract to provide certain screening services to individuals who have agreed to be bound by a proposed settlement in a legal matter. CCN signed a contract in March 2000 to provide these services for four years and the Company has agreed to have its network providers provide these services after the acquisition of CCN. The Company estimates as many as 250,000 covered persons may seek such screening services and the Company will incur a significant administrative burden in completing claims to the satisfaction of the contractual terms. No costs of this contract have been charged to the purchase reserve as of September 30, 2001. Other reserves represent various operational and tax liabilities the Company has incurred to fully integrate the Company's operations. No amounts have been charged to the reserve as of September 30, 2001. The Company reviewed the various businesses comprising the CCN Companies and determined to hold PW and the Resource Opportunity, Inc. ("ROI") business of CCN for sale. The following unaudited pro forma information reflects the results of the Company's operations as if the acquisition had occurred at the beginning of the period presented adjusted for (i) the effect of recurring charges related to the acquisition, primarily the amortization of intangible assets over estimated useful lives of 15 or 20 years, as appropriate, recording of interest expense on borrowings to finance the acquisition, the reduction of depreciation expense due to the write-down to fair value of fixed assets, the reduction of amortization expense related to the CCN Companies' preexisting goodwill at the date of acquisition and the elimination of compensation and benefit expenses for certain executives of the CCN Companies who were terminated at or immediately subsequent to the acquisition and will not be replaced, and (ii) the removal of revenues and related cost of services and expenses for acquired businesses that are held for sale. Nine Months Ended September 30, (In 000's except per share data) 2001 2000 Pro forma: ---- ---- Revenue $490,487 $449,664 Net income 76,474 58,171 Net income per common share - basic .78 .61 Net income per common share - diluted .74 .58 These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what operating results would have been had the acquisition actually taken place at the beginning of the periods presented, nor do they purport to represent results of future operations of the merged companies. 3. On May 22, 2001, the Company's Board of Directors authorized a 2-for-1 common stock split in the form of a 100% stock distribution. The stock split was paid on June 25, 2001 to stockholders of record on June 4, 2001. All historical common share amounts, per share amounts and stock option data for all periods presented have been restated to give effect to this 100% stock distribution. 4. The Company's investments in marketable securities which are classified as available for sale had a net unrealized gain in market value of $1,888,000, net of deferred income taxes, for the nine month period ended September 30, 2001. The net unrealized gain as of September 30, 2001, included as a component of stockholders' equity, was $379,000, net of deferred income taxes. The Company has six separate investments in a limited partnership which invests in equipment which is leased to third parties. The total investment as of September 30, 2001 was $44,608,000 and is accounted for using the equity method since the Company owns between a 20% and 25% interest in each particular tranche of the limited partnership. The Company's proportionate share of the partnership's income was $2,261,000 and $1,617,000 for the nine months ended September 30, 2001 and 2000, respectively, and is included in interest income. 5. The Company's Board of Directors has approved the repurchase of up to 15 million shares of the Company's outstanding common stock under its current authorization. Purchases may be made from time to time, depending on market conditions and other relevant factors. As of September 30, 2001, approximately 5.2 million shares remain available for repurchase under the Company's current repurchase authorization. 6. Weighted average shares outstanding increased for diluted earnings per share by 4,666,000 and 4,752,000 and by 3,962,000 and 3,854,000 respectively, for the three and nine months ended September 30, 2001 and 2000 due to the effect of stock options outstanding. Diluted net income per share was $.02 and $.04 less than basic net income per share for the three and nine months ended September 30, 2001 due to the effect of stock options outstanding. Diluted net income per share was $.01 and $.03 less than basic net income per share for the three and nine months ended September 30, 2000 due to the effect of stock options outstanding. 7. Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standard No. 133, ("SFAS No. 133), "Accounting For Derivative Instruments and Hedging Activities". SFAS No. 133 requires that all derivative instruments be recognized as either assets or liabilities in the balance sheet and that derivative instruments be measured at fair value. This statement also requires changes in the fair value of derivatives to be recorded each period in current earnings or comprehensive income depending on the intended use of the derivative. There was no material effect on the Company's results of operations or financial position as a result of the adoption of SFAS No. 133. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which is effective for the Company January 1, 2002. SFAS 142 requires, among other things, the discontinuance of goodwill amortization effective December 31, 2001. In addition, the standard includes provisions for the reassessment of the useful lives of existing recognized intangibles and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS 142 also requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. In accordance with these pronouncements, the Company accounted for the acquisition of CCN as a purchase and allocated the purchase price to all identifiable tangible and intangible assets and liabilities. The goodwill resulting from this acquisition of approximately $172 million has not been amortized. Goodwill and intangible assets of approximately $102 million acquired in business combinations completed before July 1, 2001 will continue to be amortized until December 31, 2001. In accordance with SFAS 142, none of the Company's $274 million in goodwill will be amortized beginning January 1, 2002. The Company expects that there will not be a transitional goodwill impairment adjustment in 2002. On August 16, 2001, the FASB issued Statement of Financial Accounting Standards No. 143 ("SFAS 143"), "Accounting for Asset Retirement Obligations", which is effective for the Company January 1, 2003. SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. On October 3, 2001, the FASB issued Statement of Financial Accounting Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets", which is effective for the Company January 1, 2002. SFAS 144 addresses accounting and reporting for the impairment or disposal of long-lived assets, including discontinued operations, and establishes a single accounting model for long-lived assets to be disposed of by sale. The Company is evaluating both pronouncements to determine their impact on the financial position and results of operations of the Company. 8. The Company and its subsidiaries are subject to various claims arising in the ordinary course of business and are parties to various legal proceedings that constitute litigation incidental to the business of the Company and its subsidiaries. The Company's wholly owned subsidiary, First Health Services Corporation ("Services") continues to be subject to an investigation by the District of Columbia Office of Inspector General (OIG"). In July 2000, the OIG issued a report evaluating the District of Columbia's ("the District") Medicaid program and suggesting ways to improve the program. Services, a subsidiary of the Company that was acquired in July 1997, has acted as the program's fiscal agent intermediary for 20 years. The OIG report included allegations that from 1993 to 1996, Services, in its role as fiscal agent intermediary, made erroneous Medicaid payments to providers on behalf of patients no longer eligible to receive Medicaid benefits. The Company does not believe that the claim or the investigation will have a material adverse effect on the Company's business or financial position. First Health Group Corp. and Subsidiaries Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Unaudited) Forward-Looking Information This Management's Discussion and Analysis of Financial Condition and Results of Operations may include certain forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including (without limitation) statements with respect to anticipated future operating and financial performance, growth and acquisition opportunities and other similar forecasts and statements of expectation. Words such as "expects", "anticipates", "intends", "plans", "believes", "seeks", "estimates", "could" and "should" and variations of these words and similar expressions, are intended to identify these forward-looking statements. Forward-looking statements made by the Company and its management are based on estimates, projections, beliefs and assumptions of management at the time of such statements and are not guarantees of future performance. The Company disclaims any obligations to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information or otherwise. Actual future performance, outcomes and results may differ materially from those expressed in forward-looking statements made by the Company and its management as a result of a number of risks, uncertainties and assumptions. Representative examples of these factors include (without limitation) general industry and economic conditions; interest rate trends; cost of capital and capital requirements; competition from other managed care companies; the ability to expand certain areas of the Company's business; shifts in customer demands; changes in operating expenses, including employee wages, benefits and medical inflation; governmental and public policy changes and the continued availability of financing in the amounts and at the terms necessary to support the Company's future business. In addition, if the Company does not continue to successfully implement new contracts and programs and control healthcare benefit expenses, or the Company is not able to successfully integrate CCN (defined below) and achieve the cost synergies anticipated as a result of the acquisition, the Company may not achieve its projected 2001 and 2002 financial results. Recent Developments On August 16, 2001, the Company completed the acquisition of all of the outstanding shares of capital stock of CCN Managed Care, Inc. ("CCN") and Preferred Works, Inc. ("PW" and together with CCN, the "CCN Companies") from HCA-The Healthcare Company and VH Holdings, Inc. (collectively, the "Sellers") for a purchase price of $195 million in cash, plus a working capital adjustment which increased the purchase price to $198 million. The acquisition was effected pursuant to the terms of a Stock Purchase Agreement, dated as of May 18, 2001 (as amended as of August 16, 2001), among the Company and the Sellers. The acquisition was financed from borrowings under the Company's existing line of credit. The Company reviewed the various businesses comprising the CCN Companies and determined to hold PW and the Resource Opportunity, Inc. ("ROI") business of CCN for sale. In conjunction with the acquisition, the Company recorded as part of the purchase price a $41.1 million reserve for restructuring and integration costs as part of an overall plan to reduce operating expenses of the acquired companies. The specific actions included in the restructuring plan are expected to be substantially complete by December 31, 2002. The actions taken to implement the restructuring plan are expected to generate in excess of $20 million in annualized savings for the Company from lower salaries and benefits costs and lower overall operating expenses, beginning in 2002. Components of the purchase reserve are as follows: Total Amount Balance (Dollars in 000's) Charges Incurred 9/30/01 ------------------ ------ ------- ------- Severance and related benefits $13,712 $ (6,764) $ 6,948 Systems and facilities integration 10,370 (4) 10,366 Contract losses 10,000 -- 10,000 Other reserves 7,031 -- 7,031 ------ ------- ------- Total $41,113 $ (6,768) $ 34,345 ====== ======= ======= The restructuring plan includes the reduction of employees from various offices within the United States. The Company is in the process of finalizing its plan, but expects to reduce the number of employees from approximately 1,300 at the time of the acquisition of CCN to approximately 650 at December 31, 2002. During the third quarter, approximately $6.8 million was paid for severance and related employee benefits. Severance and related benefits represent costs for payments over the next twelve months for headcount reductions already incurred and for future reductions of employees. Systems and facilities integration costs represent the costs the Company expects to incur to convert and integrate CCN's systems and facilities into the Company's existing operations. The majority of the facilities integration costs will be incurred to consolidate CCN's former corporate headquarters and various sales offices throughout the United States. The systems integration costs will be incurred to integrate CCN's medical provider, claims repricing and bill review systems into the Company's existing operations. Approximately $4,000 of costs for systems and facilities integration has been charged to the purchase reserve as of September 30, 2001. Contract losses relate to the anticipated net loss to be incurred on a contract to provide certain screening services to individuals who have agreed to be bound by a proposed settlement in a legal matter. CCN signed a contract in March 2000 to provide these services for four years and the Company has agreed to have its network providers provide these services after the acquisition of CCN. The Company estimates as many as 250,000 covered persons may seek such screening services and the Company will incur a significant administrative burden in completing claims to the satisfaction of the contractual terms. No costs of this contract have been charged to the purchase reserve as of September 30, 2001. Other reserves represent various operational and tax liabilities the Company has incurred to fully integrate the Company's operations. No amounts have been charged to the reserve as of September 30, 2001. On May 22, 2001, the Company's Board of Directors authorized a 2-for-1 common stock split in the form of a 100% stock distribution. The split was payable on June 25, 2001 to stockholders of record on June 4, 2001. All historical common share amounts, per share amounts and stock option data for all periods presented have been restated to give effect to this 100% stock distribution. Results of Operations The Company's revenues consist primarily of fees for cost management services provided under contracts on a percentage of savings basis (PPO) or on a predetermined contractual basis (claims administration, fee schedule, pharmacy benefit management and clinical management services). As a result of the Company's insurance company acquisitions, revenues also include premium revenue. The following table sets forth information with respect to the sources of the Company's revenues for the three and nine months ended September 30, 2001 and 2000, respectively: Sources of Revenue ($ in thousands) Three Months Ended September 30, ------------------------------ 2001 % 2000 % ------- --- ------- --- Sources of Revenue: PPO Services $ 91,112 60% $ 68,778 54% Claims Administration 41,793 27 38,100 30 Clinical Management Services 7,267 5 8,460 7 Fee Schedule Services 8,541 6 9,288 7 Premiums, Net 3,494 2 3,270 2 Service -- -- 169 -- ------- --- ------- --- Total Revenue $152,207 100% $128,065 100% ======= === ======= === ($ in thousands) Nine Months Ended September 30, ------------------------------ 2001 % 2000 % ------- --- ------- --- Sources of Revenue: PPO Services $244,927 57% $201,378 54% Claims Administration 125,867 29 113,026 30 Clinical Management Services 21,178 5 24,291 6 Fee Schedule Services 25,054 6 27,989 7 Premiums, Net 11,114 3 8,892 3 Service -- -- 848 -- ------- --- ------- --- Total Revenue $428,140 100% $376,424 100% ======= === ======= === Revenue for the three and nine months ended September 30, 2001 increased $24,142,000 (19%) and $51,716,000 (14%), respectively, from the same periods of 2000 due to strong PPO revenue which increased 32% from the third quarter of 2000 as well as $11.7 million of total revenue from CCN for the last half of the quarter. The increase in PPO revenue for the three and nine months ended September 30, is due to the addition of new clients, existing clients utilizing more PPO services, the overall increase in PPO providers and approximately $9.6 million in revenue from CCN. Claims administration revenue for the three and nine months ended September 30, 2001 increased $3,693,000 (10%) and $12,841,000 (11%) from the same periods last year due primarily to new business particularly in the commercial sector. Revenue from clinical cost management services decreased $1,193,000 (14%) and $3,113,000 (13%) for the three and nine months ended September 30, 2001 from the comparable periods in 2000. This decrease is due principally to the termination of certain healthcare management contracts with various state Medicaid programs. Revenue from fee schedule services decreased $747,000 (8%) and $2,935,000 (10%) from the comparable periods in 2000 due to a loss of business primarily from General Motors and some smaller workers' compensation carriers who have exited the business, but was aided by $1.8 million of fee schedule revenue from CCN during the quarter. Premium revenue increased $224,000 (7%) and $2,222,000 (25%) for the three and nine months ended September 30, 2001 due primarily to the addition of new stop loss insurance clients. Risk-related service revenue decreased $169,000 (100%) and $848,000 (100%) from the comparable periods of 2000, as the Company no longer offers this product. Cost of services increased $9,972,000 (18%) and $18,748,000 (11%) for the three and nine months ended September 30, 2001 from the comparable periods of 2000 principally as a result of operating costs associated with CCN for the quarter. Cost of services consists primarily of salaries and related costs for personnel involved in claims administration, PPO administration, development and expansion, utilization management programs, fee schedule and other cost management and administrative services offered by the Company. To a lesser extent, cost of services includes telephone expenses, facility expenses and information processing costs. As a percentage of revenue, cost of services remained between 44% and 45% for these same periods. Management expects to achieve significant operating efficiencies as CCN is completely integrated into the Company's business over the next 24 to 30 months. Selling and marketing costs for the three and nine months ended September 30, 2001 increased $2,791,000 (23%) and $5,581,000 (16%) from the comparable periods of 2000. The increase is due primarily to the addition of CCN costs (mainly sales personnel) and, to a lesser extent, increased expenditures for the Company's focused national marketing campaign that began in the first quarter of 2000 and to the addition of new sales personnel. General and administrative costs for the three and nine months ended September 30, 2001 increased $2,234,000 (26%) and decreased $1,991,000 (8%) from the comparable periods of 2000. The increase is primarily due to the inclusion of CCN administrative expenditures during the quarter. Healthcare benefits represent medical losses incurred by insureds of the Company's insurance entities. Healthcare benefits decreased $291,000 (9%) and increased $1,075,000 (12%) for the three and nine months ended September 30, 2001 from the comparable periods of 2000. This overall increase is due primarily to new client activity. The loss ratio (healthcare benefits as a percent of premiums) was 89% and 92% for the three and nine months ended September 30, 2001 compared to 104% and 103% for the comparable periods of 2000. The loss ratio of 89% in the third quarter of 2001 represented the third consecutive quarter that this ratio has declined. Management has reviewed its insurance business in detail and has taken appropriate action at renewal in an effort to reduce the loss ratio for 2001 and beyond. Depreciation and amortization increased $2,198,000 (22%) and $5,598,000 (20%) for the three and nine months ended September 30, 2001 from the comparable periods of 2000 due primarily to increased technology infrastructure investments made over the course of the past few years as well as various software applications which came on-line during 2000 and 2001. To a lesser extent, the increase is due to amortization of intangible assets and depreciation of fixed assets associated with the CCN acquisition. Depreciation expense will continue to grow primarily as a result of continuing investments the Company is making in its information technology infrastructure. Interest income for the three and nine months ended September 30, 2001 increased $261,000 (18%) and $428,000 (9%) from the same periods in 2000 due to slightly higher cash and investment balances available in 2001. Interest expense decreased $1,933,000 (53%) and $6,388,000 (55%) from the comparable periods of 2000 as the Company has repaid $102.5 million of debt during 2001. The Company, however, borrowed $200 million under its existing line of credit in the third quarter of 2001 to finance the CCN acquisition. The interest rate at September 30, 2001 was approximately 4.5% per annum. Net income for the three and nine months ended September 30, 2001, increased $5,611,000 (27%) and $15,195,000 (25%) from the comparable periods of 2000. This increase is due primarily to the increase in PPO revenue as well as increased efficiency in the Company operations and, to a lesser extent, the other factors discussed above. Diluted net income per common share for the three and nine months ended September 30, 2001 increased 19% to $.25 per share and 21% to $.74 per share from the comparable periods of 2000. For the three and nine months ended September 30, 2001, diluted common shares outstanding increased 4% and 3% from the comparable periods of 2000. Liquidity and Capital Resources The Company had negative working capital of $201,581,000 at September 30, 2001 compared with positive working capital of $40,270,000 at December 31, 2000. The decrease is a result of all outstanding debt under the Company's credit facility being classified as a current liability as the credit facility expires within the next twelve months. Management, however, intends to have a renewed credit facility in place prior to the expiration date. Through the first nine months of the year, operating activities provided $111,492,000 of cash. Investment activities used $261,461,000 of cash representing $198,645,000 used to acquire the CCN Companies, purchases of fixed assets of $52,225,000 and net purchases of investments of $10,591,000. Financing activities provided $143,869,000 of cash representing $215,000,000 in proceeds from issuance of long-term debt and $32,031,000 in proceeds from issuance of common stock partially offset by $102,500,000 in repayment of long-term debt and $662,000 in loans to employees to exercise stock options (net of $838,000 in loan repayments). The Company has a revolving line of credit in the amount of $350 million which expires on June 30, 2002. The Company borrowed $200 million under this credit facility during the third quarter of 2001 to finance the CCN acquisition. Management expects to have a new credit facility in place prior to the date the current facility expires. As of September 30, 2001, $240 million was outstanding under this facility. The Company believes that its working capital, long-term investments, credit facility and cash generated from future operations will be sufficient to fund the Company's anticipated operations and expansion plans. New Accounting Pronouncements Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires that all derivative instruments be recognized as either assets or liabilities in the balance sheet and that derivative instruments be measured at fair value. This statement also requires changes in the fair value of derivatives to be recorded each period in current earnings or comprehensive income depending on the intended use of the derivatives. There was no material effect on the Company's results of operations or financial position as a result of the adoption of SFAS No. 133. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which is effective for the Company January 1, 2002. SFAS 142 requires, among other things, the discontinuance of goodwill amortization effective December 31, 2001. In addition, the standard includes provisions for the reassessment of the useful lives of existing recognized intangibles and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS 142 also requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. In accordance with these pronouncements, the Company accounted for the acquisition of CCN as a purchase and allocated the purchase price to all identifiable tangible and intangible assets and liabilities. The goodwill resulting from this acquisition of approximately $172 million has not been amortized. Goodwill and intangible assets of approximately $102 million acquired in business combinations completed before July 1, 2001 will continue to be amortized until December 31, 2001. In accordance with SFAS 142, none of the Company's $274 million in goodwill will be amortized beginning January 1, 2002. The Company expects that there will not be a transitional goodwill impairment adjustment in 2002. On August 16, 2001, the FASB issued Statement of Financial Accounting Standards No. 143 ("SFAS 143"), "Accounting for Asset Retirement Obligations", which is effective for the Company January 1, 2003. SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. On October 3, 2001, the FASB issued Statement of Financial Accounting Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets", which is effective for the Company January 1, 2002. SFAS 144 addresses accounting and reporting for the impairment or disposal of long-lived assets, including discontinued operations, and establishes a single accounting model for long-lived assets to be disposed of by sale. The Company is evaluating both pronouncements to determine their impact on the financial position and results of operations of the Company. Legal Proceedings The Company and its subsidiaries are subject to various claims arising in the ordinary course of business and are parties to various legal proceedings that constitute litigation incidental to the business of the Company and its subsidiaries. The Company's wholly owned subsidiary, First Health Services Corporation ("Services") continues to be subject to an investigation by the District of Columbia Office of Inspector General (OIG"). In July 2000, the OIG issued a report evaluating the District of Columbia's ("the District") Medicaid program and suggesting ways to improve the program. Services, a subsidiary of the Company that was acquired in July 1997, has acted as the program's fiscal agent intermediary for 20 years. The OIG report included allegations that from 1993 to 1996, Services, in it role as fiscal agent intermediary, made erroneous Medicaid payments to providers on behalf of patients no longer eligible to receive Medicaid benefits. The Company does not believe that the claim or the investigation will have a material adverse effect on the Company's business or financial position. Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company's market risk exposure at September 30, 2001 is consistent with the types of market risk and amount of exposure presented in its 2000 Annual Report on Form 10-K. PART II. Other Information Item 6. Exhibits and Reports on Form 8-K Exhibits: (a) Exhibit 11 - Computation of Basic Earnings Per Common Share (b) Exhibit 11 - Computation of Diluted Earnings Per Common Share Reports on Form 8-K: The Company filed a Report on Form 8-K dated August 16, 2001 reporting under Item 2 the completion of the acquisition of CCN Managed Care, Inc. The Company also filed a Report on Form 8- K/A dated August 16, 2001 reporting under item 7, the financial statements of CCN Managed Care, Inc. and the pro forma consolidated financial statements of First Health Group Corp. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. First Health Group Corp. Dated: November 12, 2001 /s/James C. Smith ------------------------------------ James C. Smith Chairman and Chief Executive Officer Dated: November 12, 2001 /s/Joseph E. Whitters ------------------------------------ Joseph E. Whitters Chief Financial Officer (Principal Financial Officer)